Maximizing Tax-Free Gain from a Sale of a Home

Sec. 121, as amended by the Tax Reform Act of 1997 (TRA '97), provides a golden opportunity for taxpayers who may realize gain on the sale or exchange of their principal residence.

A principal residence is considered a personal-use asset. As a result, a loss on the sale or disposition of such an asset is not deductible, while a gain is subject to income taxation. Sec. 121 provides relief from this inconsistency. A portion of realized gain on the sale of a principal residence may be exempt from capital-gain tax.

Despite this, there are two caveats to the Sec. 121 exclusion rule. First, to qualify for an exclusion, a taxpayer must have owned and used the property as a principal residence for periods aggregating at least two years during the five-year period ending on the sale date. Second, if the taxpayer's realized gain exceeds the exclusion, the taxpayer must pay tax on the excess recognized gain, regardless of whether the taxpayer buys a replacement residence. The exclusion amount for a single taxpayer is $250,000; for a married couple filing jointly, it is $500,000, provided the couple meets the following requirements:

• Either spouse meets the at-least-two-years ownership requirement;
• Both spouses meet the at-least-two-years use requirement; and
• Neither spouse is ineligible for the Sec. 121 exclusion on the sale of the current principal residence because of a sale of another principal residence within the prior two years.

Tax Planning

Once a taxpayer has sold a principal residence under amended Sec. 121, the taxpayer has to calculate the taxable capital gain after considering the allowable exclusion. Each sale transaction, therefore, is taxed independently, with no need for perpetual recordkeeping.

Amended Sec. 121 provides an excellent opportunity for reducing taxes if a taxpayer does not mind selling and packing every two years.

Scenario 1: Using a Sec. 121 exclusion in conjunction with the sale of rental property. A taxpayer has a principal residence, which the taxpayer has owned and used for the past two years. The property has appreciated in value since the taxpayer purchased it. The taxpayer also has a rental residential property, purchased just a few years ago. For tax planning purposes, the taxpayer may want to take the following steps:

1. Sell the existing principal residence and benefit from the allowed exclusion under Sec. 121 (maximum $500,000, permanent capital-gain exclusion);

2. Move into the rental property and live there for at least two years, which makes the property the taxpayer's new principal residence, and qualifies the taxpayer for another maximum (or partial) exclusion under Sec. 121; and

3. Buy another rental property with the proceeds received on the sale of the principal residence.

4. After two years in the new principal residence, go back to 1.

Note: Because of Sec. 1250 depreciation recapture, the amount of tax savings on the sale of the rental residence, after the taxpayer converted it into a principal residence, is somewhat lessened. Nevertheless, the savings are still likely to be substantial.

Scenario 2: Using a Sec. 121 exclusion in conjunction with a Sec. 1031 exchange. The facts are the same as in Scenario 1, except the taxpayer's existing rental property is small and not suitable for converting to a principal residence. However, both the rental property and the presently occupied principal residence have appreciated in value since the taxpayer purchased them.

In this case, the taxpayer can apply a Sec. 1031 like-kind tax-deferred ex-change to the rental property and ac-quire a suitable new property, with the intention of renting it first for a short period and then converting it to a principal residence. The taxpayer can do this either through a direct or a delayed like-kind exchange. However, one of the requirements of Sec. 1031 is that both transferred and received properties must be business, trade or investment property—the newly ac-quired property must be a rental, not a personal-use, asset. Therefore, the taxpayer must treat the property acquired through the exchange as a rental before converting it to a principal residence. No specified minimum rental period exists for a property to be considered a rental. Thus, the length of a lease can depend on the taxpayer's circumstances. A sincere but unsuccessful effort to rent the acquired property may still classify the property as a rental.

As a result of the Sec. 1031 exchange, the taxpayer can postpone the recognition of capital gain on the disposal of the rental property, while ending up with another suitable principal residence. Because the residence in which the taxpayer has been living for the past two years has appreciated greatly in value, the taxpayer can save further by selling it and moving into the newly acquired rental house after the expiration of the short rental period.

In summary, this scenario yields two important tax-saving consequences. First, it can help the taxpayer to temporarily postpone the recognition of capital-gain tax on a Sec. 1031 exchange. Second, it can help the taxpayer permanently save capital-gain tax on the sale of a principal residence of $500,000 or less, depending on how much the property appreciated and on the taxpayer's filing status.

Scenario 3: Using a Sec. 121 exclusion in conjunction with a Sec. 1033 involuntary conversion. Because of complete or partial destruction, theft, seizure, requisition or condemnation of damaged property, a taxpayer may be forced to convert it. When damage has occurred, the taxpayer usually receives cash from a third party (such as an insurance company) to replace the property. Sometimes, the funds may exceed the property's basis, possibly resulting in gain realization. According to Sec. 1033, a taxpayer who suffered an involuntary conversion of property may postpone gain recognition on the conversion, based on the following rules:

• The amount reinvested in replacement property must be equal to or greater than the amount realized.
• If the amount reinvested in the replacement property is less than the amount realized, a partial gain might be recognized to the extent of the deficiency.

In applying the involuntary conversion rules to a personal residence, the following questions arise:

1. Is the conversion due to a casualty or a condemnation?

2. Is the result a realized loss or gain?

For a condemnation, the taxpayer does not recognize a realized loss, because the condemnation of a personal-use asset is not deductible. However, if a conversion relates to a casualty (such as a fire, an earthquake or a storm), the taxpayer does recognize a loss (subject to personal-casualty loss limits).

Nevertheless, in situations in which the taxpayer realizes gain (either under a casualty or a condemnation circumstance), the taxpayer is subject to income taxation. To avoid some of the capital-gain tax and to postpone the remaining balance, the taxpayer can use both Sec. 121 to exclude the allowed maximum gain and Sec. 1033 (involuntary conversion) to defer the remaining gain. The taxpayer thus can elect initially to exclude the Sec. 121 realized gain, to the extent of the statutory limit. The taxpayer can then use a qualified personal-residence replacement to defer the balance of the realized gain under Sec. 1033. In applying Sec. 1033, the amount of the required reinvestment is reduced by the amount of the Sec. 121 exclusion.

Option 1. Not use a Sec. 121 exclusion, but apply Sec. 1033: Fire destroyed a taxpayer's home, with a $200,000 basis. The taxpayer received $550,000 from insurance coverage and is contemplating a reinvestment of the proceeds. In Option 1, the taxpayer's realized gain is $350,000 ($550,000 – $200,000). Therefore, to defer the $350,000 realized gain, the taxpayer must purchase another home costing at least $550,000, within the time specified in Sec. 1033 (two years after the close of the tax year in which the taxpayer realizes any gain (or four years after a Predentially declared disaster)). A taxpayer who fails to do this must recognize and report a $350,000 gain.

Option 2. Use a Sec. 121 exclusion in conjunction with Sec. 1033 involuntary conversion: The facts are the same as in Option 1, except the taxpayer first reduces the $550,000 reinvestment amount by the Sec. 121 exclusion limit ($250,000 for a single taxpayer, or $500,000 for a married taxpayer filing a joint return). By using Sec. 121 first, a single taxpayer would reduce the required reinvestment to $300,000 ($550,000 – $250,000). If the taxpayer decides not to acquire another qualifying replacement property for Sec. 1033 purposes, the taxpayer would reduce the recognized gain to $100,000 ($550,000 – $200,000 – $250,000), instead of $350,000, as in Option 1. Consequently, an additional tax-free gain of $250,000 (equal to the Sec. 121 exclusion) results from using both Secs. 1033 and 121.

Under Option 2, for an involuntary conversion of a principal residence, the holding period of a replacement residence includes the holding period of the involuntarily converted residence, which may satisfy the Sec. 121 two-out-of-five-year ownership and use requirements on the subsequent sale of the replacement.

Conclusion

Since the passage of the TRA '97, a taxpayer who owns and uses a house as a principal residence can receive a substantial tax benefit from a Sec. 121 exclusion.

Further, amended Sec. 121 is lenient. Unlike the former section, it eliminated an age 55 limit and the $125,000 once-in-a-lifetime exclusion limit and, in comparison to Sec. 1034, does not have a two-year reinvestment-period requirement. The amended section provides a great opportunity for taxpayers willing to pack and move when they have a realized gain on the sale of their principal residences, but not more often than once every two years.

Taxpayers who have rental property in addition to their principal residence have a better opportunity to apply a Sec. 121 exclusion in conjunction with a Sec. 1031 like-kind exchange for further tax savings. Likewise, taxpayers can also use Sec. 121 with a Sec. 1033 involuntary conversion for further tax savings. However, taxpayers who apply Sec. 121 with Secs. 1031 and 1033 should maintain adequate records on the properties' adjusted bases, including the original cost, capital improvements and deductions that reduce basis (such as depreciation for computing future gain).

From Raj Kiani, Enrolled Agent, Professor of Accounting, D. Call, CPA, Ph.D., Professor of Accounting, and M. Sangeladji, CPA, CMA, Ph.D., Professor of Accounting, California State University, Northridge, CA (None affiliated with Baker Tilly International)